managerial accounting

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Managerial Accounting

Spring Semester 2007

Instructor: Kristen Lynch, CPA, MBA


Chapter Six

Cost-Volume-Profit Relationships


Contribution Margin

This is the amount remaining from sales revenue after variable expenses have been deducted.

Sales Revenue

Less variable expenses

Contribution Margin

Less fixed expenses

Net income


Can you guess?

What term would we use to describe the following situation?

Revenues $1,000,000

Less VC (500,000)

Contribution Margin $500,000

Less FC $500,000

Net Income 0

BREAK-EVEN!!!


Break-even Point

We call the “Break-even point” the number of units that we need to sell (or level of sales) to generate the revenues to just cover our costs (therefore breaking even)

$1,000,000 revenues/$2.50 selling price

= 400,000 units


CVP Graph

Units

Dol

lars

Fixed Expenses


CVP GraphD

olla

rs

Units

Fixed Expenses

Total Expenses


CVP Graph

Fixed Expenses

Dol

lars Total Expenses

Total Sales

Units


Let’s Practice!

• Turn to page 255 in textbook.• Exercise 6-2


Chapter 6 Objectives

• Break-even point defined• Contribution margin• Computing the break-even point• Compute level of sales to achieve xx in profit• Computing the margin of safety• Computing degree of operating leverage


Contribution Margin Ratio

The contribution margin ratio is:

For Racing Bicycle Company the ratio is:

Total CMTotal sales

CM Ratio =

Each $1.00 increase in sales results in a total contribution margin increase of 40¢.

= 40%$80,000$200,000



Or, in terms of units, the contribution margin ratio is:

For Racing Bicycle Company the ratio is:

$200$500

= 40%

Unit CMUnit selling price

CM Ratio =


400 Bikes 500 BikesSales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$

400 Bikes 500 BikesSales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$


A $50,000 increase in sales revenue A $50,000 increase in sales revenue results in a $20,000 increase in CM.results in a $20,000 increase in CM.

($50,000 × 40% = $20,000)($50,000 × 40% = $20,000)

A $50,000 increase in sales revenue A $50,000 increase in sales revenue results in a $20,000 increase in CM.results in a $20,000 increase in CM.

($50,000 × 40% = $20,000)($50,000 × 40% = $20,000)


Let’s Practice!




• Break-even point defined• Contribution margin• Computing the break-even point• Computing the margin of safety• Computing degree of operating leverage


Calculating break-even point

To calculate break-even point:

Fixed Costs = units

Contribution Margin

Fixed Costs = Sales Revenue

CM%


Let’s Practice!



Key Point

So far we are assuming that our company has only one product to sell. This is generally not the case.

Contribution margin typically varies among different types of product.

The estimate of how much of each product you are going to sell can significantly affect both total contribution margin and break even point!


Break-even points

Cakes Muffins TotalScenario AEst. sales 23,000 69,000 92,000CM 10% 20% 18%Scenario BEst. sales 40,000 20,000 60,000CM 10% 20% 13%

In cases of 2 or more products, CM% is not fixed, but can fluctuate as the sales mix changes.


The Contribution Margin Approach

The contribution margin method can be used to determine that 900 bikes must be sold to earn the target profit of $100,000.

Fixed expenses + Target profit Unit contribution margin

=Unit sales to attain

the target profit

$80,000 + $100,000 $200/bike

= 900 bikes


Let’s Practice!



The Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the

break-even volume of sales.

Margin of safety = Total sales - Break-even salesMargin of safety = Total sales - Break-even sales



If we assume that Racing Bicycle Company has actual sales of $250,000, given that we have

already determined the break-even sales to be $200,000, the margin of safety is $50,000 as shown

Break-even sales

400 unitsActual sales

500 unitsSales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$

Break-even sales





The margin of safety can also be expressed as 20% of sales.

($50,000 ÷ $250,000)

Break-even sales



Break-even sales





The margin of safety can be expressed in terms of the number of units sold. The

margin of safety at Racing is $50,000, and each bike sells for $500.

Margin ofSafety in units

= = 100 bikes$50,000

$500


Let’s Practice!



Cost Structure and Profit Stability

Cost structure refers to the relative proportion of fixed and variable costs in an organization.

Managers often have some latitude in determining their organization’s cost structure.


Cost Structure

• Would you rather have high fixed costs or variable costs?

• Discuss in small groups and we will reconvene to discuss as a class.


Cost Structure

High fixed costs Disadvantage: break-even point is higher. A lot of

pressure to make sales – runs higher risk of bankruptcy.

Key Point – Certain businesses require infrastructure – high fixed costs may not be avoidable

Advantage: Barrier to entry for possible competitors.


Operating Leverage

• The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales volume will affect profits.

Contribution margin Net operating income

Degree ofoperating leverage

=

All other things constant . . .If a firm has high fixed costs, its operating leverage will be lower than

A firm who has low fixed costs.


Operating Leverage

Actual sales 500 Bikes

Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income 20,000$

Actual sales 500 Bikes

Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income 20,000$

$100,000 $20,000

= 5

At Racing, the degree of operating leverage is 5.


Operating Leverage

With an operating leverage of 5, if Racing With an operating leverage of 5, if Racing increases its sales by 10%, net operating increases its sales by 10%, net operating

income would increase by 50%.income would increase by 50%.

Percent increase in sales 10%Degree of operating leverage × 5Percent increase in profits 50%

Here’s the verification!


Operating Leverage

10% increase in sales from$250,000 to $275,000 . . .

10% increase in sales from$250,000 to $275,000 . . .

. . . results in a 50% increase inincome from $20,000 to $30,000.. . . results in a 50% increase in

income from $20,000 to $30,000.


Let’s Practice!



Next Week

• Study for Exam

• Exam will cover Chapter 1-5

• You will have about 2 hours to complete the exam.

managerial accounting

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